HELOC Explained: How It Differs From A Home Equity Loan | NerdWallet

If you own a home, chances are you've seen its value increase substantially over the past couple of years. So you could be sitting on a decent chunk of home equity and you could put that money to work, but how do you get to the money? There's always a cash out refinance, but with mortgage interest rates going up, that's a less appealing idea since not only would you be paying potentially more interest, but also you're paying for a larger loan. A home equity line of credit could be another option. To learn more, I talked to my colleague, Taylor Gettler, who's an expert on all things HELOC. For people who are less familiar with them, can you explain what a home equity line of credit is? Sure, so a home equity line of credit, also called a HELOC, it's a second mortgage that lets you draw on the equity that you've already paid into your home. And you can use it to finance major expenses, sort of like a credit card. So it's separate from your primary mortgage. It's not a refinance, but it's an additional loan that allows you to access some of the money that you've already paid into your home. So why are HELOCs becoming more popular now? Or at least why are more homeowners potentially interested in them? So there's a couple of reasons for that. You might not have heard of the HELOC, or you might've heard some negative things about it from maybe family members who have owned a home for longer, especially if you're a more recent homeowner. Because after the financial crisis, homeowners and lenders really started getting skittish around the idea of taking out a second lien against your home. Because if the value of the home goes down, well, now you've taken more money out against it and you risk having an underwater mortgage. So that's one reason. Second of all, during the pandemic, lenders that had been offering HELOCs started pausing them because of that added risk and because we didn't know what was really gonna happen in the market with such an unprecedented event. But now that we're starting to move out of it and we're seeing home values rising so sharply, both lenders are starting to offer them again and homeowners are starting to take an interest in the idea of tapping their equity. How much equity could someone say borrow with a HELOC? Most lenders will want a minimum of at least 15 to 20%, but really the more equity that you have in your home, the better chances you'll have of qualifying and the more options that you'll have. It's also important to note that the amount of equity that you draw can impact your rates. So it really kind of is in your best interest to sit down and get a sense of how much you think you might need to withdraw so that you at least are going into it knowing about what you're going to need and what kind of rates you might be able to expect. And how do home equity loan interest rates compare to mortgage interest rates? So again, because second mortgages are riskier, they do tend to have higher rates than a mortgage rate. Now they are typically capped at around 18%, which sounds really high. You're probably never going to have to pay that, but it is unlikely that the HELOC lender is going to offer to protect it against rising rates any higher than that. That's typically the ceiling. The only instance that you would have to protect against really high rates would be to get a fixed rate HELOC. Not every lender is going to offer this. And typically, if you get a fixed rate HELOC, that rate is going to be higher than a variable rate HELOC. So it's sort of a trade-off of, you know it's not going to get any higher than that, but it's also higher than a typical variable HELOC would be. Where does the variation come from? So typically a variable rate for a HELOC is determined based on the Wall Street Journal's prime rate, which is printed on the last business day of every month. And a lender will typically have a certain variation from that prime rate. So they may say our variable rate is always going to be a quarter of a percentage lower than whatever the prime rate is, or a half a percentage. So that's good that you at least know that it's based on the same principle from lender to lender. It really just determines what kind of variation they've set. So that's variation in terms of how often the rate changes? Variation in terms of how far it deviates from the prime rate. Okay. Because I would imagine that the rate that you're going to be offered by a lender would also vary depending on your characteristics as a borrower. Absolutely. So the more qualified that you are as a borrower, the more likely that you're going to be offered a better rate. Because for the lender, they're taking on a little bit less risk, so they're willing to offer you a better rate. And again, the amount of your equity that you're pulling out also has an impact on your rate. When you're looking at different HELOC lenders, what kind of lenders should you consider? Do you have to go with the person who services your mortgage? No, you definitely don't have to go with the person that serviced your mortgage, although that can be a good place to start just because you do have a relationship with that lender. But it really is in your best interest to shop around, look at different rates, different terms, see what you can get to make sure that you're getting the best deal. Once you've found a lender that you think you like, or maybe a couple that you're going to apply to to see if you can get some different options, how do you go about applying for a HELOC? So you're going to want to get all your financial ducks in a row before you apply and make sure that you're going to be a qualified borrower. So part of that is looking at your credit score, making sure that it's at least 620, but preferably higher. Another part of it is going to be calculating your debt to income ratio. So what that means is you total up all of your monthly debts, car payments, any alimony or child support payments, and divide that by your monthly income and convert that into a percentage. So for a lender, they're going to want to see that percentage below 43%. The lower that it is, the more attractive that you're going to be as a borrower, because that means that you have less monthly debts that you're going to be obligated to pay that could potentially get in the way of you making your HELOC payments. And that sounds like a lot of math. So I think it's really fortunate that on nerdwallet.com we have a debt to income calculator. Absolutely. And so with a home equity line of credit, you can just take out some money at a time, right? It's not like a home equity loan where you say, oh, I've borrowed $100,000. You get $100,000 and that's that, right? Home equity loan works a little bit differently. Right, so with the home equity loan or any other type of personal loan, you're getting that lump sum and it's generally at that fixed rate. So really what makes a HELOC different is that it's a line of credit. Again, if you can imagine your credit card where the rate may change and you kind of use it as you need it. Today I'm spending $20, today I'm spending $40. The difference with that is that with a credit card, you're using it for small everyday purchases. With a HELOC, you really wanna only reserve it for instances where you need it and for when it's gonna be contributing to your personal wealth. So if it's going to be building an addition on your home or making some kind of repair or improvement, something that's going to add to the value, which also helps mitigate some of the risk of having a second mortgage against your home because you know that no matter what the market does, you are adding material value to the home. A HELOC works kind of like a credit card then except that you can't just charge things against your house forever, right? You really shouldn't. First of all, again, you should only use it for things that are gonna add to your wealth. And also, no, you can't do it forever. You do have a certain window of time where you're able to draw on your equity, which is called the draw period, naturally. After that period of time, which is typically about 10 years, that's when you have to start paying it back and you can't take out any more equity. Usually the way that the terms are is you'll have 20 years to pay it back, but it really depends on the lender and the terms of the loan when you took it out. It could be 15 years, 20 years, 30 years. It really just depends on the terms when you sign the loan. When you're comparing lenders, besides looking at things like interest rates, is there anything else that you should look out for with a HELOC? One thing that you can look out for is whether or not a lender requires a minimum initial draw. Now, if that minimum is what you were already gonna take out anyway, then maybe it'll work for you. But depending on your needs, really read the fine print and make sure that they're not gonna require an initial draw that's more than you're comfortable taking out. And that's especially true if you're planning on using a HELOC as a kind of backup emergency fund. That's something that you can do. If you put a lot of your savings into buying your home, you could open a HELOC as a backup emergency fund so that you know, okay, if something big happens and I need to access a lot of my money, I could access it via this way. But if you need to take out a minimum initial draw, that's something that could be a barrier. And if you didn't do that or it was a requirement, you'd get a fee or something from the lender, something like that. I believe you just, you're required to take it out. Okay, so it's, yeah, not even a choice. And that's where the credit card comparison kind of falls apart a little bit because credit cards don't usually force you to buy something immediately. Correct, and again, this is not something that every lender will require, but some do. And it's something that you're gonna wanna pay attention to in the fine print. One thing you mentioned was that during the pandemic, a lot of lenders scaled back on offering HELOCs. How can you find lenders that offer them? So in addition to starting with the lender that financed your original mortgage, you can also check out tools from experts. For example, we have a roundup where we've evaluated different lenders that offer HELOCs and we've narrowed it down to our top choices. So part of that involves whether or not they offer a fixed rate option, if that's something that you're interested in, how much they allow you to borrow, whether or not there are any annual fees. So we've done all that work for you. If you wanna take a look and start going through that list, see who's available in your area and start applying. One thing that I think is really interesting and that I was wondering if we could talk about a little bit more is the idea that HELOCs are less common, not only because lenders stopped offering them during the pandemic, but because people became so hesitant to borrow against their home equity. What's sort of different about home equity these days? Well, really what happened was after the financial crisis, everybody started looking at home values and equity a little bit differently. And they realized how much that can change. So for example, let's say that your home was valued, that it's gone up $70,000. Now you have an extra $70,000 in your equity theoretically, and you decide that you wanna take that out in a HELOC. Well, if home prices go down, you still owe that money that you've withdrawn, but now your home isn't worth that much. So you're really borrowing against the future equity of your home and you're betting on whether or not it's going to maintain its current value. So that's where the risk comes into it. And that's why after the financial crisis, people really started getting more hesitant around the idea of betting against their future equity in that way. But in today's market, obviously equity is, or at least home values are a bit different in that while we're seeing them taper off a little bit in terms of increases, we're still seeing them steadily increase. And given the relatively small number of homes for sale and the tremendous buyer demand, home values today seem much more stable and much less bubbly, let's say. It really depends on who you talk to. I mean, the bottom line is we're now in a post-financial crisis world. We now have a better sense of what to look out for and a better sense of how to detect when we're in a bubble. That being said, there is always risk when it comes to betting against the future value of your home. That's just, there is always going to be risk to it. And again, that's why the rates are a little bit higher than they are for a typical mortgage. That's why, you know, if you can't pay, you're still going to be expected to pay down your primary mortgage rather than the secondary mortgage, you know, in the instance of a financial emergency. So it is still risky. I don't want to make it seem like there's no risk involved now and that we totally figured everything out, but we are just in a different climate where that level of risk is more measured. But at the same time, it is a loan where you are using your house, your home as collateral. Exactly. And it's important to note that in the event that you can't pay your HELOC, you can get your home repossessed. You could be, you know, you could lose your home. And so that's something that we really don't want to see happen. And that's why some homeowners are so hesitant around taking on that kind of risk. So it's something that, you know, again, always be cautious when taking out a lien against your home. And again, that's also why it's so important to make sure that you're using that money for things that are going to add to your personal well. A HELOC might not be your best bet if you're only looking to borrow a little bit of money because there are some startup costs involved. If you're not looking to borrow much, you could be better off just using a personal loan. They also really aren't for you if your income is uncertain or unstable because that variable interest rate means that your payment can change over time. And last, if you're just thinking about using it to buy something fun, like a car or going on a big vacation, remember, you're using your house as collateral, really not the safest thing you could be doing. A HELOC also isn't your best option if you're planning on moving anytime soon. Why? Well, because with a HELOC, you're borrowing against your home equity. But if you no longer own the home, you can't borrow against it. That means that before you sell, you have to fully pay off your HELOC. And when you're getting ready to sell a home, the last thing you're looking for is a huge bill that you need to pay off. On the other hand, if this is your forever home, a HELOC might be a really good idea for you. HELOCs are more flexible than some of your other options, like a home equity loan. You're only paying interest on the amount that you've actually used. So you're not just paying interest on the entire line of credit, but what you've actually taken out from it. And you're not touching your primary mortgage, which is something that, especially if you refinanced in the last couple of years or you bought recently, you've got a good interest rate, you don't wanna touch it, you don't have to with a HELOC. One more thing about interest, if you use the money from your HELOC to substantially improve your home, that interest is tax deductible. I'm Kate Wood, and I write about mortgages and home ownership for NerdWallet. If you're interested in learning more about HELOCs or other ways of tapping your home equity, like home equity loans and cash out refinances, there's so much more info on our website. But as long as you're here on YouTube, why not hit like and subscribe to our channel?